HARLEYSVILLE GROUP INC – 10-K – Management’s Discussion and Analysis of Financial Condition and Results of Operations.
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Certain of the statements contained herein (other than statements of historical facts) are forward-looking statements. Such forward-looking statements are made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995 and include estimates and assumptions related to economic, competitive, legislative and regulatory developments. These forward-looking statements are subject to change and uncertainty which are, in many instances, beyond the control ofHarleysville Group Inc. (the Company) and have been made based upon management's expectations and beliefs concerning future developments and their potential effect on the Company and its wholly owned property and casualty insurance subsidiaries (collectively,Harleysville Group ). There can be no assurance that future developments will be in accordance with management's expectations or that the effect of future developments onHarleysville Group will be those anticipated by management. Actual financial results, including premium levels and underwriting results, could differ materially from those anticipated byHarleysville Group depending on the outcome of certain factors, which may include changes in property and casualty loss trends and reserves; the insurance product pricing environment; changes in applicable law; government regulation and changes therein that may impede the ability to charge adequate rates; performance of and instability in the financial markets; investment losses; fluctuations in interest rates; significant catastrophe events in the geographic regions where we do business; decreased demand for property and casualty insurance; availability and price of reinsurance; the A. M. Best group rating ofHarleysville Group ; and the status of labor markets in which the Company operates. In addition, see "Management's Discussion and Analysis - Risk Factors." 22
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Overview
The Company's net income is primarily determined by four elements:
• net premium income; • investment income and realized investment gains (losses); • amounts paid or reserved to settle insured claims; and • other income and expense.
Variations in premium income are subject to a number of factors, including:
• limitations on premium rates arising from the competitive marketplace
or regulation; • limitations on available business arising from a need to maintain the quality of underwritten risks; • the Company's ability to maintain its A (Excellent) group rating by
A.M. Best ; and
• the ability of the Company to maintain a reputation for efficiency and
fairness in claims administration.
Variations in investment income and realized investment gains (losses) are subject to a number of factors, including:
• general interest rate levels and financial market conditions;
• specific adverse events affecting the issuers of debt obligations held
by the Company; and • changes in the prices of debt and equity securities generally and those held by the Company specifically.
Loss and loss settlement expenses are affected by a number of factors, including:
• the quality of the risks underwritten by the Company; • the nature and severity of catastrophic losses; • the availability, cost and terms of reinsurance; and • underlying settlement costs, including medical and legal costs. Variations in other income and expense are affected by a number of factors, including: • the level of premiums written by the Mutual Company and its subsidiaries which are subject to the management fee;
• the amount of flood insurance written and ceded to the National Flood
Insurance Program; and • the interest rate on debt issued by the Company.
The Company seeks to manage each of the foregoing to the extent within its control. Many of the foregoing factors are partially, or entirely, outside of the control of the Company.
Critical Accounting Policies and Estimates
The consolidated financial statements are prepared in conformity with U.S. generally accepted accounting principles, which requireHarleysville Group to make estimates and assumptions (see Note 1 of the Notes to Consolidated Financial Statements).Harleysville Group believes that of its significant accounting policies, the following may involve a higher degree of judgment and estimation. The judgments, or the methodology on which the judgments are made, are reviewed quarterly with the Audit Committee. Liabilities for Losses and Loss Settlement Expenses. The liability for losses and loss settlement expenses represents estimates of the ultimate unpaid cost of all losses incurred, including losses for claims which have not yet been reported toHarleysville Group . The amount of loss reserves for reported claims is based primarily upon a case- 23
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by-case evaluation of the type of risk involved, knowledge of the circumstances surrounding each claim and the insurance policy provisions relating to the type of loss. The amounts of loss reserves for unreported claims and loss settlement expense reserves are determined utilizing historical information by line of insurance as adjusted to current conditions. Inflation is implicitly provided for in the reserving function through analysis of costs, trends and reviews of historical reserving results. Estimates of the liabilities are reviewed and updated on a regular basis using the most recent information on reported claims and a variety of actuarial techniques. It is expected that such estimates will be more or less than the amounts ultimately paid when the claims are settled. Changes in these estimates are reflected in current operations. Investments. Generally, unrealized investment gains or losses on investments carried at fair value, net of applicable income taxes, are reflected directly in shareholders' equity as a component of comprehensive income and, accordingly, have no effect on net income. However, if the fair value of an investment in equity securities declines below its cost and that decline is deemed other than temporary, the amount of the decline below cost is charged to earnings. A fixed maturity security is other than temporarily impaired if the present value of the cash flows expected to be collected is less than the amortized cost of the security or where the security's fair value is below cost and the Company intends to sell, or more likely than not will be required to sell, the security before recovery of its value. If the Company does not intend to sell, or more likely than not will not be required to sell, a fixed maturity security whose fair value has declined below its cost, the amount of the decline below cost due to credit-related reasons is charged to earnings and the remaining difference is included in comprehensive income.Harleysville Group monitors its investment portfolio and at least quarterly reviews investments that have experienced a decline in fair value below cost to evaluate whether the decline is other than temporary. Such evaluations consider, among other things, the magnitude and reasons for a decline, the prospects for the fair value to recover in the near term andHarleysville Group's intent to retain the investment for a period of time sufficient to allow for a recovery in value. Future adverse investment market conditions, or poor operating results of underlying investments, could result in an impairment charge in the future. The severe downturn in the public debt and equity markets in 2008, reflecting uncertainties associated with the mortgage crisis, worsening economic conditions, widening of credit spreads, bankruptcies and government intervention in large financial institutions, has resulted in significant realized and unrealized losses in our investment portfolio in the past. Depending on market conditions going forward, we could incur additional realized and unrealized losses in future periods. The fair value of equity securities is based on the closing market value. The fair value of mutual fund holdings is based on the closing net asset value reported by the fund. The fair value of fixed maturities is based upon data supplied by an independent pricing service. It can be difficult to determine the fair value of non-traded securities, butHarleysville Group does not own a material amount of non-traded securities. Policy Acquisition Costs. Policy acquisition costs, such as commissions, premium taxes and certain other underwriting and agency expenses that vary with and are primarily related to the production of business, are deferred and amortized over the effective period of the related insurance policies and in proportion to the premiums earned. The method followed in computing deferred policy acquisition costs limits the amount of such deferred costs to their estimated realizable value. The estimation of net realizable value takes into account the premium to be earned, related investment income over the claim paying period, expected losses and loss settlement expenses, and certain other costs expected to be incurred as the premium is earned. Future changes in estimates, the most significant of which is expected losses and loss settlement expenses, may require adjustments to deferred policy acquisition costs. If the estimation of net realizable value indicates that the deferred acquisition costs are not recoverable, they are written off and further analyses are performed to determine if an additional liability would need to be accrued. Contingencies. Besides claims related to its insurance products,Harleysville Group is subject to proceedings, lawsuits and claims in the normal course of business.Harleysville Group assesses the likelihood of any adverse outcomes to these matters as well as potential ranges of probable losses. There can be no assurance that actual outcomes will be consistent with those assessments.
The application of certain of these critical accounting policies to the years ended
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Results of Operations
Historically,Harleysville Group's results of operations have been influenced by factors affecting the property and casualty insurance industry in general. The operating results ofthe United States property and casualty insurance industry have been subject to significant variations due to competition, weather, catastrophic events, regulation, the availability and cost of satisfactory reinsurance, general economic conditions, judicial trends, fluctuations in interest rates and other changes in the investment environment.
Property and casualty insurance premiums are established before the amount of losses and loss settlement expenses, or the extent to which inflation may affect such expenses, are known. Consequently,Harleysville Group attempts, in establishing rates, to anticipate the potential impact of inflation. In the past, inflation has contributed to increased losses and loss settlement expenses. The key elements ofHarleysville Group's business model are the sales of properly priced and underwritten personal and commercial property and casualty insurance through independent agents and the investment of the premiums in a manner designed to assure that claims and expenses can be paid while providing a return on the capital employed. Loss trends and investment performance are critical factors in influencing the success of the business model. These factors are affected by the factors impacting the insurance industry in general as described above and factors unique toHarleysville Group as described in the following discussion. Transactions with Affiliates OnSeptember 28, 2011 , the Company andHarleysville Mutual Insurance Company (the Mutual Company) entered into an agreement and plan of merger (the Merger Agreement) withNationwide Mutual Insurance Company (Nationwide) under which a subsidiary of Nationwide would merge into the Company. Nationwide would acquire all of the publicly held shares of common stock of the Company for$60.00 per share in cash, and the Mutual Company would merge into Nationwide and the policyholders and members of the Mutual Company would become policyholders and members of Nationwide.The Mutual Company has also entered into a voting agreement with Nationwide (the Voting Agreement) under which the Mutual Company agreed to vote its 53% voting interest in the Company in favor of the Merger. The Merger Agreement restricts the Company from engaging in certain activities and taking certain actions without Nationwide's prior approval, including among others, the payment of stockholder dividends. The transactions are subject to customary closing conditions, including, among others, approvals from stockholders of the Company, policyholders of the Mutual Company and Nationwide, thePennsylvania Insurance Department , theOhio Insurance Department and various other regulatory bodies. The transactions are expected to close in the first half of 2012. The Merger Agreement provides certain termination rights. In the event that the agreement is terminated under certain conditions by the Company's Board of Directors, the Company will be required to pay Nationwide a termination fee of$29.6 million and reimburse Nationwide for its transaction expenses. The Company's property and casualty subsidiaries participate in a pooling agreement with the Mutual Company and its property and casualty insurance subsidiary,Harleysville Pennland Insurance Company (Pennland). The pooling agreement provides for the allocation of premiums, losses, loss settlement expenses and underwriting expenses betweenHarleysville Group and the Mutual Company.Harleysville Group is not liable for any losses incurred by the Mutual Company or Company subsidiariesHarleysville Preferred Insurance Company (Preferred) and Harleysville Insurance Company of New Jersey (HNJ) prior toJanuary 1, 1986 , the date the pooling agreement became effective, or for certain business assumed by the Mutual Company effectiveJanuary 1, 2010 .Harleysville Group's participation in the pool has been 80% sinceJanuary 1, 2008 . EffectiveJanuary 1, 2011 , the Company's property and casualty subsidiaries and the Mutual Company and Pennland amended their intercompany pooling agreement as it relates to their workers compensation business. The amendment established that the financial results associated with the workers compensation business for accident years 25
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2011 and following will be retained 100 percent by the Mutual Company. The financial results of this business for prior accident years will continue to be shared between the Company's property and casualty subsidiaries, the Mutual Company and Pennland under the existing pool participations.Harleysville Group paid cash of$33 million onJanuary 3, 2011 associated with the transfer of the unearned premium liability on the workers compensation business as ofJanuary 1, 2011 .Harleysville Group's unearned premium liability decreased by$40 million andHarleysville Group received a ceding commission of$7 million for expenses that were incurred to generate the business transferred to the Mutual Company, which ceding commission reduced deferred policy acquisition costs. Because the pooling agreement does not relieveHarleysville Group of primary liability as the originating insurer, there is a concentration of credit risk arising from business ceded to the Mutual Company. However, the pooling agreement provides for the right of offset and the amount of credit risk with the Mutual Company was not material atDecember 31, 2011 and 2010.The Mutual Company has an A. M. Best rating of "A" (Excellent). OnDecember 30, 2010 ,Harleysville Group Inc. acquiredMainland Insurance Company (Mainland) from the Mutual Company for$4,825,000 in cash. OnDecember 31, 2010 , HIC New York was merged into Mainland and Mainland's name was changed toHarleysville Insurance Company of New York (HIC New York). As a result of this transaction, HIC New York was redomesticated fromNew York toPennsylvania .Harleysville Ltd. is a subsidiary of the Company and leases the home office to the Mutual Company, which shares the facility withHarleysville Group . Rental income under the lease was$4.5 million ,$4.4 million and$4.2 million for 2011, 2010 and 2009, respectively, and is included in other income after elimination of intercompany amounts of$3.2 million ,$3.0 million and$2.9 million in 2011, 2010 and 2009, respectively. The lease had a five-year term expiringDecember 31, 2009 and included a formula for additional rent for any additions, improvements or renovations. The lease was renewed for one-year periods expiringDecember 31, 2012 ,December 31, 2011 andDecember 31, 2010 under its prior terms.The Mutual Company is responsible for the building operating expenses including maintenance and repairs. The pricing of the lease was based upon an appraisal obtained from an independent real estate appraiser.Harleysville Group provides certain management services to the Mutual Company and other affiliates.Harleysville Group received a fee of$8.5 million ,$5.8 million and$5.1 million in 2011, 2010 and 2009, respectively, for its services under these management agreements. EffectiveJanuary 1, 2010 , the management agreement was amended to include voluntary assumed reinsurance business written by the Mutual Company. The level of fees has been approved by each state insurance department having jurisdiction. Under related agreements,Harleysville Group serves as the paymaster for the Harleysville companies, with each company being charged for its proportionate share of salary and employee benefits expense. The Company's insurance subsidiaries and the Mutual Company are parties to an Equipment and Supplies Allocation Agreement whereby equipment and supplies are shared between parties. Ultimate expense for such items is allocated toHarleysville Group based on its pooling participation.The Mutual Company has purchased and developed certain equipment and software which is expensed byHarleysville Group based on its pooling participation as the items are depreciated or amortized.
Intercompany balances are created primarily from the pooling arrangement (settled quarterly), allocation of common expenses, collection of premium balances and payment of claims (settled monthly). No interest is charged or received on intercompany balances due to the timely settlement terms and nature of the items.
Harleysville Group borrowed$18.5 million from the Mutual Company in connection with the acquisition ofHarleysville Insurance Company of New York (HIC New York) in 1991. It was a demand loan with a stated maturity inMarch 1998 which had been extended toMarch 2005 . InFebruary 2005 , the maturity was extended again toMarch 2012 and the interest rate becameLIBOR plus 0.45%, which was a commercially reasonable market rate in 2005. Interest expense on this loan was$0.1 million ,$0.1 million , and$0.3 million in 2011, 2010 and 2009, respectively.
Off Balance Sheet Arrangements
Harleysville Group has off-balance-sheet credit risk related to approximately$97.3 million and$99.6 million of premium balances due to the Mutual Company from agents and insureds atDecember 31, 2011 and 2010, 26
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respectively.The Mutual Company bills and collects such receivables on behalf ofHarleysville Group for efficiency reasons.Harleysville Group recognizes any associated bad debts, which have not been material.
2011 Compared to 2010
Premiums earned decreased$61.8 million , or 7.1%, for the year endedDecember 31, 2011 compared to the prior year primarily due to the change to the pooling agreement effectiveJanuary 1, 2011 , whereby premiums earned on workers compensation business is retained 100% by the Mutual Company. Excluding 2010 premiums earned on workers compensation business, premiums earned increased 2.1% for the year endedDecember 31, 2011 compared to the prior year. Premiums earned for commercial lines decreased$83.8 million , or 12.4%, compared to the prior year primarily due to the change to the pooling agreement described in the preceding paragraph. Excluding 2010 premiums earned on workers compensation business, premiums earned decreased 0.9% for the year endedDecember 31, 2011 compared to the prior year. Premiums earned for personal lines increased$22.0 million , or 11.6%, compared to the prior year primarily due to higher average premiums and greater policy counts. Investment income decreased$7.9 million for the year endedDecember 31, 2011 , primarily due to a lower investment yield on fixed income securities and lower average invested assets, partially offset by greater dividends on equity securities. Average invested assets were lower due to negative operating cash flow in 2011 and use of the proceeds from the sale of these investments to pay dividends in 2011 and 2010, and repurchase shares in 2010. Net realized investment gains increased$74.9 million for the year endedDecember 31, 2011 , compared to the prior year primarily due to gains on the sale of equity securities in 2011. InOctober 2011 , the Company sold virtually all of its equity securities, at a gain of$62 million , in order to reduce potential volatility in statutory surplus. Prior to this sale, the Company recognized impairment charges of$3.6 million on equity securities. Impairment charges of$0.4 million were also recognized on fixed maturity securities the Company sold in 2011. There were no credit-related impairment charges in 2010.Harleysville Group holds securities with unrealized losses atDecember 31, 2011 as follows: Length of Unrealized Loss Unrealized Less Than Fair Value Loss 12 Months (in thousands) Fixed maturities: Obligations of states and political subdivisions $ 8,976 $ 19 $ 19 Corporate securities 7,956 29 29 Total temporarily impaired securities $ 16,932 $ 48 $ 48 Of total fixed maturity securities with an unrealized loss atDecember 31, 2011 , securities with a fair value of$11.0 million and an unrealized loss of$22,000 are classified as available for sale and are carried at fair value on the balance sheet while securities with a fair value of$6.0 million and an unrealized loss of$26,000 are classified as held to maturity on the balance sheet and are carried at amortized cost. The unrealized losses on fixed maturity investments were primarily due to the expected call of a municipal bond and the widening of credit spreads on securities in the financial sector. Per the Company's policy, a fixed maturity security is other than temporarily impaired if the present value of the cash flows expected to be collected is less than the amortized cost of the security or where the security's fair value is below cost and the Company intends to sell or more likely than not will be required to sell the security before recovery of its value. The Company believes, based on its analysis, that these securities are not other than temporarily impaired. However, depending on developments involving both the issuers and worsening economic conditions, these investments may be written down in the income statement in the future. 27
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The fair value and amortized cost of general obligation and special revenue bonds held by the Company as of
Fair Value Amortized Cost (in thousands) General obligation bonds $ 864,584 $ 789,370 Special revenue bonds 363,576 336,982 Total $ 1,228,160 $ 1,126,352
For each category above, no state, municipality or political subdivision comprised more than 10% of the total.
The break-down of the special revenue bonds category, by nature of activity for activities comprising more than 10% of the category, is as follows:
Amortized Moody's Average Fair Value Cost Credit Rating (dollars in thousands) Education $ 116,167 $ 106,130 Aa Water & sewer 97,839 91,071 Aaa Transportation 48,759 45,294 Aa Escrowed To Maturity/Pre-refunded 41,252 39,640 Aa Total $ 304,017 $ 282,135
Income before income taxes decreased
An insurance company's statutory combined ratio is a standard measure of underwriting profitability. This ratio is the sum of (1) the ratio of incurred losses and loss settlement expenses to net earned premium, (2) the ratio of expenses incurred for commissions, premium taxes, administrative and other underwriting expenses to net written premium, and (3) the ratio of dividends to policyholders to net earned premium. The combined ratio does not reflect investment income, federal income taxes or other non-operating income or expense. A ratio of less than 100 percent generally indicates underwriting profitability.Harleysville Group's statutory combined ratio increased to 119.9% for the year endedDecember 31, 2011 from 102.5% for the year endedDecember 31, 2010 . The combined ratio for 2011 includes 0.9% due to the impact of the statutory treatment of the ceding commission received on the unearned premiums transferred to the Mutual Company onJanuary 1, 2011 . Excluding the impact of the pool transfer, the statutory combined ratio was 119.0% for 2011. The increase in the combined ratio was primarily due to greater catastrophe losses, greater non-catastrophe weather losses and less favorable development in 2011. Net catastrophe losses increased to$93.2 million (11.6 points) for 2011 from$35.7 million (4.1 points) for 2010. 28
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The statutory combined ratios by line of business for the year endedDecember 31, 2011 as compared to the year endedDecember 31, 2010 are shown below. For the Year Ended December 31, 2011 2010 Commercial: Automobile 105.4 % 100.0 % Workers compensation 106.1 % Commercial multi-peril 127.6 % 106.1 % Other commercial 98.7 % 88.8 % Total commercial 116.7 % 102.3 % Total commercial without intercompany pooling transfer 115.4 % Personal: Automobile 119.4 % 104.9 % Homeowners 148.9 % 108.2 % Other personal 75.9 % 62.6 % Total personal 129.3 % 103.5 % Total personal and commercial
119.9 % 102.5 % Total personal and commercial without intercompany pooling transfer
119.0 %
The commercial lines statutory combined ratio increased to 115.4% (excluding the impact of the pooling transfer) for the year endedDecember 31, 2011 from 102.3% for the year endedDecember 31, 2010 . This increase was primarily due to unusually high catastrophe and non-catastrophe weather losses experienced in all four quarters of 2011. In the first quarter of 2011, unusually severe winter weather resulted in catastrophe and non-catastrophe losses that contributed to elevated loss activity, particularly in the Northeast and Mid-Atlantic regions. In the second quarter of 2011, all regions were significantly impacted by catastrophes, with the Southeast and Midwest regions being most adversely affected due to tornado and hail losses. In the third quarter of 2011, Hurricane Irene, Tropical Storm Lee, and other hail and windstorm events contributed to significant losses, particularly in the Northeast and Mid-Atlantic regions. In the fourth quarter of 2011, an unusual October snow event contributed to losses in the Mid-Atlantic and the Northeast regions. Catastrophe losses in the commercial lines represented 9.2 points of the combined ratio in calendar year 2011 compared to 2.6 points in calendar year 2010. The commercial automobile line of business also contributed to the overall increase in the commercial lines combined ratio in 2011. The increase in the commercial automobile combined ratio from 100.0% for the year endedDecember 31, 2010 to 105.4% for the year endedDecember 31, 2011 is primarily due to higher than expected frequency and severity in accident year 2011. The personal lines statutory combined ratio increased to 129.3% for the year endedDecember 31, 2011 from 103.5% for the year endedDecember 31, 2010 . The increase in the personal lines combined ratio for the year endedDecember 31, 2011 is primarily due to higher catastrophe and non-catastrophe weather losses affecting property coverages during 2011. The unusually severe weather described for commercial lines also impacted personal lines during 2011. Catastrophe losses in the personal lines represented 18.3 points of the combined ratio in calendar year 2011 compared to 9.7 points in calendar year 2010. The personal automobile line of business also contributed to the overall increase in the personal lines combined ratio in 2011. The increase in the personal automobile combined ratio from 104.9% for the year endedDecember 31, 2010 to 119.4% for the year endedDecember 31, 2011 is primarily due to higher than expected frequency and severity in accident years 2010 and 2011. Reserves for unpaid losses and loss settlement expenses are estimated for case reserves and losses incurred but not reported (IBNR) separately. The sum of case reserves and IBNR represents the Company's estimate of total unpaid loss and loss settlement expense. Case reserves are determined for each reported claim by the Company's claims organization reflecting the known circumstances of the individual claim. The Company's actuaries calculate IBNR by reducing their estimate of ultimate loss and loss settlement expense by cumulative paid loss and loss settlement expense and case reserves. Ultimate losses are re-estimated for each line of business on a quarterly basis using the most current loss and claim data as of the quarter end. 29
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In addition to analyzing reserves on a line of business basis, reserving categories are identified and reviewed. For example, the following categories for the Commercial Auto Liability line of business are analyzed quarterly: Commercial Auto Liability Bodily Injury; Commercial Auto Liability Property Damage; and Commercial Auto Liability Excess. In the discussion that follows, these categories are referred to by the label "line of business." In the course of our quarterly reserve estimation process, several standard loss reserving methods and procedures are utilized to derive estimates of ultimate loss for each line of business, including: • Paid Loss Development Method • Incurred Loss Development Method
• Incurred Counts and Averages Method (Based on Exponential Fit of Severity)
• Bornhuetter-Ferguson Method Any individual method used to estimate loss reserves has its advantages and disadvantages based on trends, changes within the external business environment, changes in internal company processes and procedures and any bias that may be inherent in the methodology. The actuaries give consideration to the relative strengths and weaknesses of each of the methods to derive a selected point estimate within the range. Following is a general description of each of the methods used: • Paid Loss Development Method: The Paid Loss Development Method uses historical payment patterns to project future payments as of a given evaluation date to ultimate loss. Estimates using this method are not
affected by changes in case reserving practices that might have occurred
during the review period, but may be understated as this method does not
take into account large unpaid claims. This method is also susceptible to
any changes in the rate of claim settlements or shifts in the size of claims settled. A number of indications of ultimate loss may be produced from the Paid Loss Development Method since a number of loss development factors (LDFs) may be selected. The actuaries produce and review several indications of ultimate loss using this method based on various LDF selections as judged appropriate, such as: • 3-Year Average (straight average and loss-weighted average) • 5-Year Average (straight average and loss-weighted average) • 5-Year Excluding Highest and Lowest LDFs • All-Year loss-weighted average • Selected LDF Pattern (LDFs are selected for each evaluation based on the actuaries' review of the historical development) • Incurred Loss Development Method: The Incurred Loss Development Method is
similar to the paid method, but instead uses historical incurred (case
reserves plus payments) patterns to project future incurred losses as of a
given evaluation date to ultimate loss. In many cases, the incurred
development method is preferred over the paid method as it includes the
additional information provided by the aggregation of individual case reserves. The resulting LDFs tend to be lower and more stable than those of the paid development method. However, the incurred development method
may be affected by changes in case reserving practices and any unusually
large individual claims.
As with the Paid Loss Development Method, various indications of ultimate loss may be produced from the Incurred Loss Development Method. The actuaries produce and review several indications of ultimate loss using this method based on various LDF selections.
• Incurred Counts and Averages Method: This method is used to estimate
ultimate loss by separately estimating ultimate counts and severity
(average loss per claim) components of ultimate loss. Both the ultimate
claim counts and ultimate severity are estimated using a loss development
factor approach similar to the Incurred Loss Development Method. For this
reason, the same considerations discussed in the
Method apply to this method as well. 30
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An ultimate severity is selected by fitting a curve to the historical ultimate severities indicated using the ratio of the ultimate loss and ultimate claim counts. This method yields ultimate severities that are based on the underlying historical trends in the data. Ultimate claim counts and ultimate severities are multiplied together to produce an estimate of ultimate losses. This method is useful in more recent accident years where the data is not mature and is especially useful when loss development patterns are volatile or not well established.
• Bornhuetter-Ferguson Method: The Bornhuetter-Ferguson Method is a blended
method that explicitly takes into account both actual loss development to
date and expected future loss emergence. Two versions of this method may
be used: one based on paid loss and one based on incurred loss. This
method uses the selected loss development patterns from the Development
Methods to calculate the expected percentage of loss unpaid (or
unreported). The expected component of the method is calculated by
multiplying earned premium for the given exposure period by a selected a
priori loss ratio. The resulting dollars are then multiplied by the
expected percentage of unpaid (or unreported) loss described above. This
provides an estimate of future loss payments (or reporting) that is then
added to actual paid (or incurred) loss data to produce estimated ultimate
loss.
Each of the methodologies described above (and their derivatives) are reviewed for each line of business. This approach allows the actuaries to identify and respond to the unique characteristics of each line of business. Further, since long-term historical data is reviewed, changes in development patterns within a line of business may likewise be identified and considered in the actuaries' process of selecting ultimate loss. An actuarial central estimate, which is management's best estimate, of ultimate loss is selected for each line of business based on a review of the indications produced by the above methodologies. More consideration is given to those methods that the actuaries deem to be more appropriate in a particular situation. In addition, other metrics such as claim closing ratios, average case reserve levels, paid loss to incurred loss ratios, individual large loss information, and recent insurance pricing changes are reviewed to help the actuaries select the most appropriate estimates of ultimate loss.
The selection of the ultimate loss is based on information unique to each line of business and accident year and the judgment and expertise of the actuaries.
• Short-Tail versus
described above are generally applied to each line of business, regardless
of their classification as short-tail or long-tail. "Tail" refers to the
time period between the occurrence of a loss and the final settlement of
the claim. The merits of an individual reserving method relative to the line of business and age of accident period are considered in the actuaries' process of selecting ultimate loss. Short-tail lines of business, by definition, develop to their ultimate value faster than long-tail lines of business. Property coverages including inland marine along with automobile physical damage coverages are considered short-tail lines of business. Automobile Liability, General Liability,Commercial Multi-Peril Liability and Workers' Compensation are considered long-tail lines of business. For many liability claims, significant periods of time may elapse between the occurrence of the loss, the reporting of the loss, and the final settlement of the claim. Workers' Compensation claims can result in providing medical benefits and wage replacement over the course of an injured worker's lifetime. In general, more consideration may be given to the results of the development methodologies for short-tail lines than to long-tail lines for accident periods of the same maturity. For example, the indicated ultimate loss using the Incurred Loss Development Method for the most recent accident year is generally considered more reliable for a short-tail line, such as Homeowners Property, than a long-tail line, such as Workers' Compensation. As mentioned previously, the selection of ultimate loss is based on information unique to each line of business and accident year subject to exceptions, such as the emergence of one or more unusually large claims in a particular accident period for a short-tail line. In this case, the indications produced by the development methods may be overstated (due to development of ultimate losses to amounts in excess of policy limits) and such information would be considered in the actuaries' process of selecting ultimate loss. 31
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• Immature Accident Periods: The Paid Loss Development Method is generally
given less consideration than the Incurred Loss Development Method for less mature accident periods since the relatively low magnitude of losses
paid at early evaluations tends to result in less reliable indications
from the Paid Loss Development Method. For long-tail lines of business,
neither the Incurred nor the
significant consideration for the most recent accident period. This is due
to the fact that the relatively low magnitude of losses either incurred or
paid at early evaluations tends to result in less reliable indications
from these methods.
In faster developing, short-tailed lines such as Auto Physical Damage, Special Property, Homeowners, Commercial Multi-Peril Property and Property Damage, the Paid Loss Development Method, the Incurred Loss Development Method and the Bornhuetter-Ferguson methods are primarily used as they typically produce tightly clustered projections for all accident years. The estimation of loss reserves for long-tail lines such as Commercial Auto Liability, Commercial Multi-Peril Liability, and Workers Compensation is more complex and is subject to a higher degree of variability than for short-tail lines of business.
The following table presents the liability for unpaid losses and loss settlement expenses by major line of business:
December 31, 2011 2010 (in thousands) Commercial: Automobile $ 272,590 $ 288,289 Workers compensation 307,453 370,838 Commercial multi-peril 679,849 634,145 Other commercial 144,983 143,070 Total commercial 1,404,875 1,436,342 Personal: Automobile 87,714 78,505 Homeowners 49,955 36,427 Other personal 2,860 2,791 Total personal 140,529 117,723 Total personal and commercial 1,545,404 1,554,065 Plus reinsurance recoverables 244,187 217,596 Total liability $ 1,789,591 $ 1,771,661 The following table presents the increase (decrease) in the estimated ultimate loss and loss settlement expenses attributable to insured events of prior years for the year endedDecember 31, 2011 by line of business: 32
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Increase (Decrease) in the Estimated Ultimate Loss and Loss Settlement Expenses Attributable to Insured Events of Prior Years For the Year Ended December 31, 2011 Accident Years 2008 and Total 2010 2009 Prior Years (in thousands) Line of Business Commercial: Automobile $ (5,646 ) $ 1,145 $ (544 ) $ (6,247 ) Workers compensation (11,787 ) 3,149 1,656 (16,592 ) Commercial multi-peril (10,596 ) 3,089 1,148 (14,833 ) Other commercial (2,809 ) 1,573 (1,950 ) (2,432 ) Total commercial (30,838 ) 8,956 310 (40,104 ) Personal: Automobile (70 ) 6,283 670 (7,023 ) Homeowners (867 ) 1,026 828 (2,721 ) Other personal (286 ) (72 ) (326 ) 112 Total personal (1,223 ) 7,237 1,172 (9,632 ) Total net development $ (32,061 ) $ 16,193 $ 1,482 $ (49,736 ) In 2011,Harleysville Group recognized net favorable development of$32.1 million in the provision for insured events of prior years, primarily due to lower-than-expected claims severity broadly experienced across casualty lines in accident years 2003 through 2008, partially offset by adverse development in accident years 2009 and 2010. A decrease in commercial automobile severity, primarily in accident years 2005 through 2009, was observed during 2011, which led to the recognition of favorable development in these accident years. Slightly higher than expected severity was observed in accident year 2010, which led to the recognition of adverse development in this accident year. In aggregate,$5.6 million of favorable prior year development was recognized in this line during 2011.
A decrease in workers compensation severity, primarily in accident years 2003 through 2008, was observed during 2011, which led to the recognition of favorable development in these accident years. An increase in severity was observed in accident years 2009 and 2010, which led to the recognition of adverse development in these accident years. In aggregate,
A decrease in commercial multi-peril severity was widely observed during 2011, which led to the recognition of favorable development in most accident years prior to 2009. An increase in severity was observed in accident years 2009 and 2010, which led to the recognition of adverse development in these years. In aggregate,$10.6 million of favorable prior year development was recognized in this line during 2011. A decrease in other commercial lines severity, primarily in accident years 2007 through 2009, was observed during 2011, which led to the recognition of favorable development in these accident years. An increase in severity was observed in accident year 2010, which led to the recognition of adverse development in this accident year. In aggregate,$2.8 million of favorable prior year development was recognized in this line during 2011. A decrease in personal automobile severity in accident years 2008 and prior was widely observed during 2011, which led to the recognition of favorable development in these accident years. An increase in severity was observed in accident years 2009 and 2010, which led to the recognition of adverse development in these accident years. In aggregate,$0.1 million of favorable prior year development was recognized in this line during 2011. 33
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A decrease in homeowners severity in accident years 2008 and prior was widely observed during 2011, which led to the recognition of favorable development in these accident years. An increase in severity was observed in accident years 2009 and 2010, which led to the recognition of adverse development in these accident years. In aggregate,$0.9 million of favorable prior year development was recognized in this line during 2011.
A slight decrease in other personal lines severity was observed during 2011, primarily in accident year 2009. In aggregate,
In 2010,Harleysville Group recognized net favorable development of$50.1 million</money> in the provision for insured events of prior years, primarily due to lower-than-expected claims severity broadly experienced across all casualty lines in accident years 2004 through 2008, partially offset by a slight amount of adverse development in accident years prior to 2000. A decrease in commercial automobile severity was observed during 2010, which led to the recognition of $8.1 million of favorable development in this line during the year. Approximately$2.4 million of the favorable development experienced in this line during 2010 is related to the Company's involuntary pools. A decrease in workers compensation severity, primarily in accident years 2002 through 2007, was observed during 2010 and led to the recognition of favorable development for those accident years during the year. An increase in workers compensation medical severity in accident years 2001 and prior was observed during 2010, which led to the recognition of adverse development for those accident years during the year. An increase in severity in accident year 2009 was observed in this line during 2010, which led to the recognition of$1.2 million of adverse development during the year. In total,$8.2 million of favorable development was recognized in the workers compensation line during 2010. Approximately$2.6 million of the favorable development experienced in this line during 2010 is related to the Company's involuntary pools.
In the commercial multi-peril line of business, a reduction in severity, primarily in accident years 2004 through 2009, led to the recognition of
A reduction in other commercial lines severity was widely observed during 2010, which led to the recognition of
A reduction in personal automobile severity in accident years 2008 and prior was widely observed during 2010. Claim frequency in accident year 2009 increased, which led to$0.5 million of adverse development during the year. In total,$4.4 million of favorable prior year development was recognized in this line during 2010. A reduction in homeowners severity was observed during 2010, especially in accident year 2006. Claim frequency and severity in accident years 2008 and 2009 were observed to increase slightly, which led to the recognition of$0.4 million and$0.1 million of adverse development in these years, respectively. In total,$0.3 million of favorable development was recognized in this line during 2010. A reduction in other personal lines severity was observed during 2010, especially in accident year 2005. Severity in accident years 2008 and 2009 was observed to marginally increase, which led to the recognition of$0.1 million of adverse development in each accident year. In total,$0.7 million of favorable development was recognized in other personal lines during 2010. The tables below break out the change in the estimate of ultimate losses betweenDecember 31, 2010 andDecember 31, 2011 for the 2010, 2009, 2008 and 2007 accident years into severity and frequency components for the major commercial and personal lines of business. Table 1 summarizes the Company's percentage change in the estimate of ultimate loss and loss settlement expense by line of business betweenDecember 31, 2010 andDecember 31, 2011 . Tables 2 and 3 summarize the Company's percentage change in the estimate of ultimate severity and ultimate claim counts, respectively. The relationship between the three tables is as follows: (1+ the % change in estimated ultimate loss) = (1+ the % change in estimated ultimate severity) x (1+ the % change in estimated ultimate claim counts). The estimated ultimate severity is calculated as the ratio of estimated ultimate loss to estimated ultimate claim counts. The amounts underlying these tables are based on direct loss and claim experience minus ceded loss experience and exclude a small portion of losses associated with business assumed from involuntary pools. 34
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Percentage Increase (Decrease) in Ultimate Loss and Loss Settlement Expense
Between the Years EndedDecember 31, 2010 andDecember 31, 2011 Accident Years 2010 2009 2008 2007 Line of Business Commercial: Automobile 0.9 % -0.4 % -1.4 % -1.0 % Workers compensation 4.5 % 2.2 % -2.8 % -3.2 % Commercial multi-peril 1.2 % 0.5 % -0.9 % -1.3 % Other commercial 3.2 % -4.1 % -2.7 % -4.8 % Total commercial 1.8 % 0.1 % -1.5 % -1.8 % Personal: Automobile 8.4 % 1.1 % -1.0 % -0.9 % Homeowners 1.6 % 1.7 % -1.2 % -2.6 % Other personal -1.4 % -6.2 % 2.9 % -1.0 % Total personal 5.0 % 1.0 % -0.9 % -1.6 % Total All Lines 2.5 % 0.3 % -1.4 % -1.8 % Table 2 Percentage Increase (Decrease) in Ultimate Severity
Between the Years EndedDecember 31, 2010 andDecember 31, 2011
Accident Years 2010 2009 2008 2007 Line of Business Commercial: Automobile 1.1 % -0.6 % -1.3 % -1.0 % Workers compensation 4.0 % 1.6 % -3.1 % -3.3 % Commercial multi-peril 4.4 % 1.2 % -0.4 % -1.0 % Other commercial 8.9 % -4.1 % -3.0 % -3.6 % Total commercial 3.2 % 0.1 % -1.4 % -1.7 % Personal: Automobile 7.1 % 1.0 % -1.0 % -0.9 % Homeowners 0.5 % 1.5 % -1.2 % -2.6 % Other personal -1.3 % -6.0 % 2.7 % -1.0 % Total personal 3.9 % 0.9 % -0.9 % -1.6 % Total All Lines 2.6 % 0.2 % -1.4 % -1.7 % 35
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Table of Contents Table 3 Percentage Increase (Decrease) in Ultimate Claim Counts Between the Years EndedDecember 31, 2010 andDecember 31, 2011 Accident Years 2010 2009 2008 2007 Line of Business Commercial: Automobile -0.2 % 0.2 % -0.1 % 0.0 % Workers compensation 0.5 % 0.6 % 0.4 % 0.2 % Commercial multi-peril -3.0 % -0.7 % -0.5 % -0.3 % Other commercial -5.2 % 0.0 % 0.2 % -1.2 % Total commercial -1.3 % 0.0 % -0.1 % -0.1 % Personal: Automobile 1.2 % 0.1 % 0.1 % 0.0 % Homeowners 1.1 % 0.2 % 0.0 % -0.1 % Other personal -0.1 % -0.2 % 0.2 % 0.0 % Total personal 1.1 % 0.1 % 0.0 % 0.0 % Total All Lines -0.1 % 0.0 % 0.0 % -0.1 % These tables illustrate that the changes to the Company's estimates of ultimate loss for prior accident years betweenDecember 31, 2010 andDecember 31, 2011 are primarily driven by the severity component of loss. In this context, the term "severity" does not refer to an actuarial assumption, rather, it refers to "severity" as a descriptive statistic derived from the ratio of estimated ultimate loss to estimated ultimate claim counts. In general, as estimates of the ultimate number of claims were relatively stable for the prior accident periods, the changes in estimates of ultimate loss are characterized as resulting from a reduction in severity. In general, those lines of business with a relatively low underlying volume of data, such as other commercial lines and other personal lines, are subject to greater variability in both claim severity and claim count development.Harleysville Group records the actuarial central estimate, which is management's best estimate, of the ultimate unpaid losses and loss settlement expenses incurred. The estimate represents the actuarially determined expected amount of future payments on all loss and loss settlement expenses incurred on or beforeDecember 31, 2011 . Actuarial loss reserving techniques and assumptions, which rely on historical information as adjusted to reflect current conditions, have been consistently applied, after including consideration of recent case reserve activity, during the periods presented. Changes in the estimate of the liability for unpaid losses and loss settlement expenses reflect actual payments and evaluations of new information and data since the last reporting date. These changes correlate with actuarial trends. The following table presents the liability for unpaid losses and loss settlement expenses by case and incurred but not reported (IBNR) reserves by line of business and a statistically determined range of estimates of the ultimate unpaid losses and loss settlement expenses incurred for each line of business as ofDecember 31, 2011 . The range of estimates around the actuarial central estimates is statistically determined in order to provide information regarding the variability of the actuarial central estimates. The statistical analysis is completed only on a basis that is net of reinsurance recoverables, as this appropriately reflectsHarleysville Group's risk profile based on the type and quality of its reinsurance. The range is determined using the Monte Carlo Simulation method. This method uses the Company's actual historical loss data to estimate the mean and standard deviation of a statistical distribution for future loss development. There have been no adjustments made to the historical data. The Company's application of the Monte Carlo Simulation assumes that loss development factors are normally distributed with a mean and standard deviation derived from the historical data. Reserve ranges are determined using both paid and incurred loss development data with a 10,000 trial simulation run against each set of data for each line of business presented in the table below. Each simulation generates a unique set of loss development factors randomly generated from the normal distribution with mean and standard deviation as defined above. Each unique set of loss development factors, when applied to the data, produces 36
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a unique reserve estimate. At the completion of the simulation, there are 20,000 unique reserve estimates which can be ordered from lowest to highest creating a range of reserve estimates. The resulting range produced by the simulation is used to create a reasonable representation of a 90% confidence interval using the 5% point as the low end of the range and the 95% point as the high end of the range. The 90% confidence interval represents the range of reserve estimates for which there is approximately a 90% probability that the actual reserve amount (which will not be known for many years) is contained within the defined range. The total commercial lines range and total personal lines range were developed as separate simulations using the means and standard deviations of the individual lines as inputs. Therefore, the 90% confidence interval for all lines of business is smaller than the straight sum of the individual lines of business 90% intervals. The use of this technique to analyze reserve ranges assumes historical data has validity in predicting future outcomes. This assumption is consistent with a key assumption underlying much of insurance pricing and reserving theory. Liability for Unpaid Losses and Loss Settlement Expenses (LAE) at December 31, 2011 Statistically Determined LAE IBNR Total Range of Estimates Case IBNR Liability (Inc. LAE) Liability High Low (in thousands) Line of Business Commercial: Automobile $ 95,774 $ 127,245 $ 49,571 $ 176,816 $ 272,590 $ 327,518 $ 207,987 Workers compensation 131,269 130,920 45,264 176,184 307,453 334,938 238,766 Commercial multi-peril 185,179 311,776 182,894 494,670 679,849 791,081 557,586 Other commercial 28,828 80,866 35,289 116,155 144,983 186,249 82,846 Total commercial 441,050 650,807 313,018 963,825 1,404,875 1,568,315 1,112,365 Personal: Automobile 42,010 29,944 15,760 45,704 87,714 100,360 66,875 Homeowners 17,199 24,086 8,670 32,756 49,955 66,068 35,558 Other personal 975 1,489 396 1,885 2,860 2,891 1,686 Total personal 60,184 55,519 24,826 80,345 140,529 163,431 108,590 Total net liability 501,234 706,326 337,844 1,044,170 1,545,404 Reinsurance recoverables 166,033 76,239 1,915 78,154 244,187 Gross liability $ 667,267 $ 782,565 $ 339,759 $ 1,122,324 $ 1,789,591 Reinsurance recoverables were$245.9 million and$219.1 million atDecember 31, 2011 and 2010, respectively. Of these amounts,$137.7 million and$102.3 million , respectively, or 56% and 47%, respectively, of the recoverables were due from governmental bodies, regulatory agencies or quasi governmental pools and reinsurance facilities where,Harleysville Group believes, there is limited credit risk. The remainder of the reinsurance recoverables are principally due from reinsurers rated A- or higher by theA.M. Best Company . Ceded reinsurance contracts do not relieveHarleysville Group's primary obligation to its policyholders. Consequently, an exposure exists with respect to reinsurance recoverables to the extent that any reinsurer is unable to meet its obligation or disputes the liabilities assumed under the reinsurance contract. From time to time,Harleysville Group may encounter such disputes with its reinsurers. In addition, the creditworthiness of our reinsurers could deteriorate in the future due to adverse events affecting the reinsurance industry, such as a large number of major catastrophes. Because of the nature of insurance claims, there are uncertainties inherent in the estimates of ultimate losses.Harleysville Group's reorganization of its claims operation in recent years has resulted in new people and processes involved in settling claims. As a result, more recent statistical data reflects different patterns than in the past and gives rise to uncertainty as to the pattern of future loss settlements. There are uncertainties regarding future loss cost trends 37
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particularly related to medical treatments and automobile repair. Court decisions, regulatory changes and economic conditions can affect the ultimate cost of claims that occurred in the past. Accordingly, the ultimate liability for unpaid losses and loss settlement expenses will likely differ from the amount recorded atDecember 31, 2011 . The property and casualty industry has had substantial aggregate loss experience from claims related to asbestos-related illnesses, environmental remediation, product liability, mold, and other uncertain exposures.Harleysville Group has not experienced significant losses from such claims.
The income tax expense for the year ended
2010 Compared to 2009
Premiums earned increased$7.8 million , or 0.9%, for the year endedDecember 31, 2010 compared to the prior year primarily due to an increase of$21.2 million in premiums earned for personal lines, partially offset by a decrease of$13.4 million in premiums earned for commercial lines. The increase in premiums earned for personal lines was 12.6%, primarily due to new business writings and higher average premiums. The decrease in premiums earned for commercial lines was 1.9%, primarily due to lower average premiums, lower exposures and a decline in assumed premiums earned from involuntary pools. Investment income decreased$3.3 million for the year endedDecember 31, 2010 , primarily due to a lower investment yield on fixed income securities and short-term investments and a greater percentage of fixed income securities invested in tax-exempt securities. During the second half of 2010,Harleysville Group purchased an additional$50 million of equity securities in order to generate additional investment income. Investments were made in high-quality, large-cap companies with strong balance sheets and a history of paying and increasing their dividends. In 2011,Harleysville Group plans to add an additional$120 million to dividend paying equities, with$50 million of this amount resulting from a re-allocation of its broad-based equity index fund. Net realized investment gains decreased$1.7 million for the year endedDecember 31, 2010 , compared to the prior year. There were no credit-related impairment charges in 2010 and credit-related impairment charges of$1.5 million on non-equity securities in 2009. The 2009 impairment charges consisted of$0.5 million on bonds which were sold in 2010 and$1.0 million on structured investment vehicles.
Income before income taxes decreased
Harleysville Group's statutory combined ratio increased to 102.5% for the year endedDecember 31, 2010 from 99.8% for the year endedDecember 31, 2009 . The increase in the combined ratio was primarily due to greater catastrophe losses and greater non-catastrophe property losses in 2010, partially offset by greater favorable development in 2010. Net catastrophe losses increased to$35.7 million (4.1 points) for 2010 from$6.2 million (0.7 points) for 2009. The 2010 catastrophe losses were primarily due to a series of severe winter storms in the first quarter and several wind and hail events during the second and third quarters. 38
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Table of ContentsThe statutory combined ratios by line of business for the year endedDecember 31, 2010 as compared to the year endedDecember 31, 2009 are shown below: For the Year Ended December 31, 2010 2009 Commercial: Automobile 100.0 % 91.4 % Workers compensation 106.1 % 106.2 % Commercial multi-peril 106.1 % 105.1 % Other commercial 88.8 % 97.6 % Total commercial 102.3 % 100.7 % Personal: Automobile 104.9 % 103.0 % Homeowners 108.2 % 92.7 % Other personal 62.6 % 81.1 % Total personal 103.5 % 96.8 % Total personal and commercial 102.5 % 99.8 % The commercial lines statutory combined ratio increased to 102.3% for the year endedDecember 31, 2010 from 100.7% for the year endedDecember 31, 2009 . This increase was primarily due to the commercial automobile line of business for which the statutory combined ratio increased to 100.0% for the year endedDecember 31, 2010 from 91.4% for the year endedDecember 31, 2009 . The increase in the commercial automobile combined ratio is primarily due to the recognition of 4.5 points of favorable development from prior accident years in 2010, compared to the recognition of 10.9 points of favorable development from prior accident years in 2009. The commercial multi-peril line of business also contributed to the increase in the commercial lines statutory combined ratio in the year. The commercial multi-peril statutory combined ratio increased to 106.1% for the year endedDecember 31, 2010 from 105.1% for the year endedDecember 31, 2009 , primarily due to a higher level of property losses compared to the prior year. The personal lines statutory combined ratio increased to 103.5% for the year endedDecember 31, 2010 from 96.8% for the year endedDecember 31, 2009 . The increase in the personal lines combined ratio for the year endedDecember 31, 2010 primarily relates to a higher incidence of personal lines catastrophe losses during 2010 (9.7 points) compared to the catastrophe losses in 2009 (1.0 points). Catastrophe losses in the homeowners line of business were significantly higher during 2010 (20.1 points) compared to 2009 (1.6 points). 39
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The following table presents the increase (decrease) in the estimated ultimate loss and loss settlement expenses attributable to insured events of prior years for the year endedDecember 31, 2010 by line of business: Increase (Decrease) in the Estimated Ultimate Loss and Loss Settlement Expenses Attributable to Insured Events of Prior Years For the Year Ended December 31, 2010 Accident Years 2007 and Total 2009 2008 Prior Years (in thousands) Line of Business Commercial: Automobile $ (8,071 ) $ 490 $ (402 ) $ (8,159 ) Workers compensation (8,184 ) 1,228 (391 ) (9,021 ) Commercial multi-peril (18,945 ) (4,084 ) (1,722 ) (13,139 ) Other commercial (9,626 ) (1,000 ) (3,346 ) (5,280 ) Total commercial (44,826 ) (3,366 ) (5,861 ) (35,599 ) Personal: Automobile (4,356 ) 506 (948 ) (3,914 ) Homeowners (270 ) 81 413 (764 ) Other personal (677 ) 92 109 (878 ) Total personal (5,303 ) 679 (426 ) (5,556 ) Total net development $ (50,129 ) $ (2,687 ) $ (6,287 ) $ (41,155 ) In 2010,Harleysville Group recognized net favorable development of$50.1 million in the provision for insured events of prior years, primarily due to lower-than-expected claims severity broadly experienced across all casualty lines in accident years 2004 through 2008, partially offset by a slight amount of adverse development in accident years prior to 2000. A decrease in commercial automobile severity was observed during 2010, which led to the recognition of$8.1 million of favorable development in this line during the year. Approximately$2.4 million of the favorable development experienced in this line during 2010 is related to the Company's involuntary pools. A decrease in workers compensation severity, primarily in accident years 2002 through 2007, was observed during 2010 and led to the recognition of favorable development for those accident years during the year. An increase in workers compensation medical severity in accident years 2001 and prior was observed during 2010, which led to the recognition of adverse development for those accident years during the year. An increase in severity in accident year 2009 was observed in this line during 2010, which led to the recognition of$1.2 million of adverse development during the year. In total,$8.2 million of favorable development was recognized in the workers compensation line during 2010. Approximately$2.6 million of the favorable development experienced in this line during 2010 is related to the Company's involuntary pools.
In the commercial multi-peril line of business, a reduction in severity, primarily in accident years 2004 through 2009, led to the recognition of
A reduction in other commercial lines severity was widely observed during 2010, which led to the recognition of
A reduction in personal automobile severity in accident years 2008 and prior was widely observed during 2010. Claim frequency in accident year 2009 increased, which led to$0.5 million of adverse development during the year. In total,$4.4 million of favorable prior year development was recognized in this line during 2010. A reduction in homeowners severity was observed during 2010, especially in accident year 2006. Claim frequency and severity in accident years 2008 and 2009 were observed to increase slightly, which led to the recognition of$0.4 million and$0.1 million of adverse development in these years, respectively. In total,$0.3 million of favorable development was recognized in this line during 2010. 40
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A reduction in other personal lines severity was observed during 2010, especially in accident year 2005. Severity in accident years 2008 and 2009 was observed to marginally increase, which led to the recognition of$0.1 million of adverse development in each accident year. In total,$0.7 million of favorable development was recognized in other personal lines during 2010.
Other income increased
The income tax expense for the year ended
New Accounting Standards
InJanuary 2010 , theFinancial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2010-06, "Fair Value Measurements and Disclosures." ASU 2010-06 applies to all entities that are required to make disclosures about recurring or non-recurring fair value measurements. ASU 2010-06 provides guidance on additional disclosures on any significant transfers in and out of Level 1 and Level 2 and a description of the transfer. ASU 2010-06 also requires separate disclosures of the activity in the Level 3 category related to any purchases, sales, issuances and settlements on a gross basis. The effective date of the new disclosures relating to the existing disclosures regarding Level 1 and Level 2 categories is for interim and annual periods beginning afterDecember 15, 2009 . The effective date of the disclosures regarding purchases, sales, issuances and settlements to the Level 3 category is for interim and annual periods beginning afterDecember 15, 2010 . The adoption of this ASU did not have a material impact on the Company's results of operations or financial position. InOctober 2010 , the FASB issued ASU 2010-26, "Accounting for Costs Associated with Acquiring or Renewing Insurance Contracts (a consensus of theFASB Emerging Issues Task Force )." This ASU amends FASB Accounting Standards Codification (ASC) Topic 944,Financial Services-Insurance , to address which costs related to the acquisition of new or renewal insurance contracts qualify for deferral. The ASU allows insurance entities to defer costs related to the acquisition of new or renewal insurance contracts that are (1) incremental direct costs of the contract transaction (i.e., would not have occurred without the contract transaction), (2) a portion of the employee's compensation and fringe benefits related to certain activities for successful contract acquisitions, or (3) direct-response advertising costs as defined in ASC Subtopic 340-20, Other Assets and Deferred Costs - Capitalized Advertising Costs. An insurance entity would expense as incurred all other costs related to the acquisition of new or renewal insurance contracts. The amendments in the ASU are effective for fiscal years, and interim periods within those years, beginning on or afterDecember 15, 2011 , and can be applied either prospectively or retrospectively. Early application is permitted at the beginning of an entity's annual reporting period. The Company will adopt this guidance prospectively. During 2012, the Company estimates that pre-tax expenses will increase by approximately$20 million , as a lower amount of acquisition costs will be capitalized and amortization of the greaterDecember 31, 2011 balance will continue. InDecember 2010 , the FASB issued ASU 2010-28, "Intangibles-Goodwill and Other." The amendments in this ASU modify Step 1 of the goodwill impairment test for reporting units with zero or negative carrying amounts. For these units, an entity is required to perform Step 2 of the goodwill impairment test if it is more likely than not that a goodwill impairment exists. In determining whether it is more likely than not that a goodwill impairment exists, an entity should consider whether there are any adverse qualitative factors indicating that an impairment may exist. For public entities, this ASU is effective for fiscal years, and interim periods within those years, beginning afterDecember 15, 2010 . The adoption of this ASU did not have a material impact on the Company's results of operations or financial position. InMay 2011 , the FASB issued ASU 2011-04, "Fair Value Measurement: Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs." The amendments in this ASU result in common fair value measurement and disclosure in U.S. GAAP and IFRSs. The amendments change the wording used to describe many of the requirements in U.S. GAAP for measuring fair value and for disclosing information about fair value measurements. The amendments include: (1) those that clarify the FASB's intent about the application of existing fair value measurement and disclosure requirements; and (2) those that change a particular principle or requirement for measuring fair value or for disclosing information about fair value measurement. For public entities, the amendments in this ASU are effective during interim and annual periods beginning afterDecember 15, 2011 , and are to be applied prospectively. Early application by public entities is not permitted. The adoption of this ASU will not have a material impact on the Company's results of operations or financial position.
In
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in this ASU, an entity has the option to present the total of comprehensive income, the components of net income, and the components of other comprehensive income either in a single continuous statement of comprehensive income or in two separate but consecutive statements. InDecember 2011 , the FASB amended this guidance to postpone the requirement to present on the face of the financial statements reclassification adjustments for items that are reclassified from other comprehensive income to net income where the components of net income and the components of other comprehensive income are presented and reinstate previous guidance related to such reclassifications. For public entities, the amendments in this ASU are effective for fiscal years, and interim periods within those years, beginning afterDecember 15, 2011 , and are to be applied retrospectively. Early adoption is permitted. The adoption of this ASU will not have a material impact on the Company's results of operations or financial position. InSeptember 2011 , the FASB issued ASU 2011-08, "Testing Goodwill for Impairment." The amendments in this ASU permit an entity to first assess qualitative factors to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount as a basis for determining whether it is necessary to perform the two-step goodwill impairment test described in ASC Topic 350, Intangibles-Goodwill and Other. Previous guidance under this topic required an entity to test goodwill for impairment, on at least an annual basis, by comparing the fair value of a reporting unit with its carrying amount. If the fair value of the reporting unit is less than its carrying amount, then the second step of the test must be performed to measure the amount of the impairment loss, if any. Under the amendments in this ASU, an entity is not required to calculate the fair value of a reporting unit unless the entity determines that it is more likely than not that its fair value is less than its carrying amount. This ASU is effective for annual and interim goodwill impairment tests performed for fiscal years beginning afterDecember 15, 2011 . The adoption of this ASU will not have a material impact on the Company's results of operations or financial position.
Liquidity and Capital Resources
Liquidity is a measure of the ability to generate sufficient cash to meet cash obligations as they come due.Harleysville Group's primary sources of cash are premium income, investment income and maturing investments. Cash outflows can be variable because of uncertainties regarding settlement dates for liabilities for unpaid losses and because of the potential for large losses, either individually or in the aggregate. Accordingly,Harleysville Group maintains investment and reinsurance programs generally intended to provide adequate funds to pay claims without forced sales of investments.Harleysville Group models its exposure to catastrophes and has the ability to pay claims without selling held to maturity securities even for events having a low (less than 1%) probability. Even in years of greater catastrophe frequency,Harleysville Group generally has been able to pay claims without liquidating any investments.Harleysville Group has also considered scenarios of declines in revenue and increases in loss payments, and believes it has the ability to meet cash requirements under such scenarios without selling held to maturity securities.Harleysville Group's policy with respect to fixed maturity investments is to purchase only those that are of investment grade quality. Operating activities used net cash of$77.4 million and provided net cash of$98.2 million for 2011 and 2010, respectively. The 2011 amount includes$33.0 million paid in connection with the change to the intercompany pooling agreement effectiveJanuary 1, 2011 . The remaining decrease of$142.6 million is due to a decrease in underwriting cash flow, primarily from an increase in paid losses from greater catastrophe losses and a decrease in premiums due to the change in the pooling agreement. Investing activities provided net cash of$104.5 million and used net cash of$2.8 million for 2011 and 2010, respectively. The change is primarily due to net sales of investments in 2011 due to the use of cash by operating activities and financing activities. Following the execution of the Merger Agreement, the Company determined that it was prudent to sell its equity securities portfolio holdings to reduce risks that could negatively impact the Company's ability to meet various financial covenant closing conditions set forth in the Merger Agreement. Such sales occurred in the fourth quarter of 2011. Financing activities used net cash of$27.1 million and$95.6 million for 2011 and 2010, respectively. The decrease is primarily due to a decrease in dividends paid and a decrease in the purchase of treasury stock in 2011.Harleysville Group's investment strategy is designed to complement and support the insurance operations.Harleysville Group considers projected cash flow (premiums, investment income, reinsurance programs, liability payout patterns, general expenses, large seasonal obligations, intercompany transfers, etc.) to assure that sufficient 42
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liquidity exists withinHarleysville Group and the Mutual Company. Maintaining a regular maturity schedule in readily marketable securities is an essential part of addressing liquidity. This regular maturity schedule is maintained in all interest rate environments. After-tax yield will be maximized consistent with safety and liquidity considerations by investment in taxable or tax-exempt securities, depending onHarleysville Group's tax position. The Company had$43.4 million of cash and marketable securities atDecember 31, 2011 , which are available for general corporate purposes including dividends, debt service, capital contributions to subsidiaries, acquisitions and the repurchase of stock. OnJuly 30, 2009 , the Board of Directors authorized the Company to repurchase up to 800,000 shares of its outstanding common stock over a two year period in the open market or in privately negotiated transactions. Additionally, the Board authorized the Company to make purchases under the terms of a Rule 10b5-1 trading plan, which allows the Company to purchase its shares at times when it ordinarily would not be in the market because of self-imposed trading blackout periods, such as the time preceding its quarterly earnings releases or because its officers are in possession of material, non-public information. The Company repurchased shares in open market transactions from the public float, and did not repurchase shares from the Mutual Company. This program was completed onAugust 3, 2010 . OnAugust 6, 2010</chron>, the Board of Directors authorized the Company to repurchase up to an additional 800,000 shares of its common stock over a two year period under terms similar to the repurchase authorization of July 30, 2009 . As ofDecember 31, 2011 , the Company had repurchased 245,084 shares under this authorization, leaving 554,916 shares authorized to be repurchased. Provisions in the Merger Agreement with Nationwide restrict the Company from repurchasing further shares.Harleysville Group has no other material commitments for capital expenditures as ofDecember 31, 2011 . As a holding company, the Company's principal source of cash for the payment of stockholder dividends is dividends from its insurance subsidiaries. The Company's insurance subsidiaries are subject to state laws that restrict their ability to pay dividends. The Company's insurance subsidiaries declared dividends of$19.3 million and paid dividends of$43.4 million in 2011 ($24.1 million of which had been declared in 2010). The Company's insurance subsidiaries declared dividends of$89.0 million and paid dividends of$94.3 million in 2010 ($29.5 million of which had been declared in 2009). Applying the current regulatory restrictions as ofDecember 31, 2011 ,$65.1 million would be available for distribution to the Company by its subsidiaries in 2012 without prior regulatory approval. See the Business-Regulation section of this Annual Report on Form 10-K, which includes a reconciliation of net income and shareholders' equity as determined under statutory accounting practices to net income and shareholders' equity as determined in accordance with accounting principles generally accepted inthe United States of America . Also, see Note 9 of the Notes to Consolidated Financial Statements. TheNational Association of Insurance Commissioners (NAIC) adopted risk-based capital (RBC) standards that require insurance companies to calculate and report statutory capital and surplus needs based on a formula measuring underwriting, investment and other business risks inherent in an individual company's operations. These RBC standards have not affected the operations ofHarleysville Group since each of the Company's insurance subsidiaries has statutory capital and surplus in excess of RBC requirements. These RBC standards require the calculation of a ratio of total adjusted capital to Authorized Control Level. Insurers with a ratio below 200% are subject to different levels of regulatory intervention and action. Based upon their 2011 statutory financial statements, the ratio of total adjusted capital to the Authorized Control Level for the Company's six insurance subsidiaries atDecember 31, 2011 ranged from 406% to 721%. The following summarizesHarleysville Group's contractual obligations atDecember 31, 2011 : Less Than More than Total 1 Year 1-3 Years 4-5 Years 5 Years (in thousands) Contractual obligations: Debt $ 118,500 $ 18,500 $ 100,000 Interest on debt $ 8,894 $ 5,779 $
3,115
Gross liability for unpaid losses and loss settlement expenses $ 1,789,591 $ 427,613 $ 471,421 $ 235,736 $ 654,821 Total $ 1,916,985 $ 451,892 $ 574,536 $ 235,736 $ 654,821 43
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The table above does not include capital lease obligations, operating lease obligations or purchase obligations as they are either not applicable or not material. The timing of the amounts for the gross liability for unpaid losses and loss settlement expenses is an estimate based on historical experience and expectations of future payment patterns. However, the timing of these payments may vary significantly from the amounts stated above.
Risk Factors
You should consider carefully the following risks, as well as the other information contained in this 2011 Annual Report on Form 10-K. If any of the following events described in the risk factors below actually occur, our business, financial condition and results of operations could be materially adversely affected. You should refer to the other information set forth in this 2011 Annual Report on Form 10-K including our consolidated financial statements and the related notes.
Risks Related to the Property and Casualty Insurance Industry Generally
If our estimated liability for losses and loss settlement expenses is incorrect, our reserves may not be adequate to cover our ultimate liability for losses and loss settlement expenses and may have to be increased. We are required to maintain loss reserves for our estimated liability for losses and loss settlement expenses associated with reported and unreported claims for each accounting period. We regularly review our reserving techniques and our overall amount of reserves and, based on our estimated liability, raise or lower the levels of our reserves accordingly. If our estimates are incorrect and our reserves are inadequate, we are obligated to increase our reserves. An increase in reserves results in an increase in losses and a reduction in our net income for the period in which the deficiency in reserves is identified. Accordingly, an increase in reserves could have a material adverse effect on our results of operations, liquidity and financial condition. Our reserve amounts are estimated based on what we expect our ultimate liability for losses and loss settlement expenses to be. These estimates are based on facts and circumstances of which we are aware, predictions of future events, trends in claims severity and frequency and other subjective factors. Although we use a number of actuarial methods to project our ultimate liability, there is no method that can always exactly predict our ultimate liability for losses and loss settlement expenses.
In addition to reviewing our reserving techniques, as part of our reserving process we also consider:
• information regarding each claim for losses; • our loss history and the industry's loss history;
• legislative enactments, judicial decisions and legal developments
regarding damages; • changes in political attitudes; and • trends in general economic conditions, including inflation.
If certain catastrophic events occur, including increased claims related to changing climate conditions, they could have a significant impact on our operating results and financial condition.
Results of property insurers are subject to weather and other events prevailing in any given year. While one year may be relatively free of major weather or other disasters, another year may have numerous such events causing results for that year to be materially worse than for other years. Our insurance subsidiaries have experienced, and are expected in the future to experience, catastrophe losses. It is possible that a catastrophic event or a series of multiple catastrophic events could have a material adverse effect on the operating results and financial condition of our insurance subsidiaries, thereby limiting the ability of our insurance subsidiaries to pay dividends to us. The largest non-flood catastrophe to affect our results of operations was Hurricane Irene in the third quarter of 2011, which resulted in$28.0 million of losses. In 2010, we experienced losses totaling$37.7 million from twenty-seven different catastrophes. In 2011, we experienced losses totaling$91.5 million from twenty-five different catastrophes. Various events can cause catastrophes, including severe winter weather, hurricanes, windstorms, earthquakes, hail, war, terrorism, explosions and fires. The frequency and severity of these catastrophes are inherently unpredictable. The extent of losses from a catastrophe is a function of both the total amount of insured exposures in the area affected by the event and the severity of the event. 44
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Our insurance subsidiaries seek to reduce the impact on our business of a catastrophe through geographic diversification and through the purchase of reinsurance covering various categories of catastrophes, which generally excludes terrorism. Nevertheless, reinsurance may prove inadequate if:
• a major catastrophic loss exceeds the reinsurance limit; or
• an insurance subsidiary pays a number of smaller catastrophic loss
claims that, individually, fall below the subsidiary's retention level. In addition, we use models developed by third party vendors in assessing our property exposure to catastrophe losses that assume various conditions and probability scenarios. These models do not necessarily accurately predict future losses. We are heavily regulated in the states in which we operate and if we violate those regulations or if the regulations unreasonably restrict our ability to do business, or if they change significantly, it could have a material adverse effect on our business. We are subject to extensive supervision and regulation in the states in which we transact business. The purpose of supervision and regulation is to protect individual policyholders and not stockholders or other investors. Our business can be adversely affected by private passenger automobile insurance regulations and any other regulations affecting property and casualty insurance companies. For example, laws and regulations can reduce or set rates at levels that we do not believe are adequate for the risks we insure. Other laws and regulations can limit our ability to cancel or refuse to renew policies and require us to offer coverage to all consumers. Changes in laws and regulations, or their interpretations, pertaining to insurance, including workers compensation, may also have a material adverse effect on our business. Although the federal government does not directly regulate the insurance industry, federal initiatives, such as federal terrorism backstop legislation, from time to time, also can impact the insurance industry. Although we do not write health insurance, rules affecting health care services can affect other insurance that we write, including workers compensation and commercial and personal automobile and liability insurance. We cannot determine whether or in what form additional health care reform legislation may be adopted by theU.S. Congress or any state legislature. We also cannot determine the nature and effect, if any, that the adoption of health care legislation or regulations, or changing interpretations, at the federal or state level would have on us. InJuly 2010 , the Dodd-Frank Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act) was signed into law. Among other things, the Dodd-Frank Act established a Federal Insurance Office within theU.S. Department of the Treasury and empowered it to gather data and information regarding the insurance industry and insurers. We cannot predict what impact, if any, the Dodd-Frank Act or any other such legislation will have on us. We currently write flood insurance which is reinsured by the National Flood Insurance Program (the NFIP). There have been various legislative proposals to reform or terminate the NFIP. We cannot currently determine whether or in what form legislation may be adopted concerning the NFIP and the effect this may have on us. OnJanuary 7, 2011 , theSouth Carolina Supreme Court held in Crossmann vHarleysville Mutual Insurance Company (Opinion No. 26909,January 7, 2011 ) that a contractor's or subcontractor's negligent/faulty work does not constitute an "occurrence" under the applicable Commercial general liability policy. InMay 2011 , theSouth Carolina legislature passed legislation to overturn the Crossmann decision. The law purported to impact all pending and future claims. The constitutionality of the retroactive application of the legislation is now being challenged. We can not currently determine the effect that this constitutional challenge may have on the legislation or the effect of this legislation onHarleysville Group .
If demand for property and casualty insurance decreases, it could have a material adverse impact on our business.
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Historically, the results of the property and casualty insurance industry have been subject to significant fluctuations over time due to competition and due to unpredictable developments, including: • natural and man-made disasters; • fluctuations in interest rates and other changes in the investment environment that affect returns on our investments; • inflationary pressures that affect the size of losses; and • legislative and regulatory changes and judicial decisions that affect insurers' liabilities. The demand for property and casualty insurance, particularly commercial lines, also can vary with the overall level of economic activity. Any of the foregoing could reduce the demand for property and casualty insurance, which would have a material adverse effect on our business, including on the amount of premiums earned in any fiscal quarter or fiscal year.
If we are unable to reduce our exposure to risks through reliable reinsurance or if the cost of reinsurance increases, our risk of loss, or the cost of controlling our risk of loss, will increase.
We transfer a portion of our exposure to selected risks to other insurance and reinsurance companies through reinsurance arrangements. Under our reinsurance arrangements, another insurer assumes a specified portion of our losses and loss adjustment expenses in exchange for a specified portion of policy premiums. The availability, amount and cost of reinsurance depend on market conditions and may vary significantly. Any decrease in the amount of our reinsurance will increase our risk of loss. Furthermore, we face a credit risk when we obtain reinsurance because we are still liable for the transferred risks if the reinsurer cannot meet the transferred obligations. Therefore, the inability of any of our reinsurers to meet its financial obligations could materially and adversely affect our financial condition and results of operations.
The threat of terrorism and military and other actions may result in decreases in our net income, revenue and assets under management and may materially adversely affect our investment portfolio.
The threat of terrorism, both withinthe United States and abroad, and military and other actions and heightened security measures in response to these types of threats, may cause significant volatility and declines in the financial markets inthe United States ,Europe and elsewhere, as well as loss of life, property damage, additional disruptions to commerce and reduced economic activity. Actual terrorist attacks could cause losses from insurance claims related to the property and casualty insurance operations ofHarleysville Group , as well as a decrease in our shareholders' equity, net income and/or revenue. The effects of changes related toHarleysville Group may result in a decrease in our stock price. The Terrorism Risk Insurance Act of 2002, which was originally extended in 2005 and extended again in 2007, requires that some coverage for terrorist loss be offered by primary property insurers and provides Federal assistance for recovery of claims through 2014. In addition, some of the assets in our investment portfolio may be materially adversely affected by declines in the financial markets and economic activity caused by the continued threat of terrorism, ongoing military and other actions and heightened security measures. We cannot predict at this time whether and the extent to which industry sectors in which we maintain investments may suffer losses as a result of potential decreased commercial and economic activity, or how any such decrease might impact the ability of companies within the affected industry sectors to pay interest or principal on their securities, or how the value of any underlying collateral might be affected. We can offer no assurances that the threats of future terrorist-like events inthe United States and abroad or military actions bythe United States will not have a material adverse effect on our business, financial condition or results of operations. Certain changes in the accounting standards issued by theFinancial Accounting Standards Board or other standard-setting bodies could have a material adverse impact on our reported net income. We are subject to the application of U.S. GAAP and other accounting standards, which are periodically revised and/or expanded. As such, we are required to adopt new or revised accounting standards issued by recognized authoritative bodies, including theFinancial Accounting Standards Board . It is possible that future changes required to be adopted could change the current accounting treatment that we apply and such changes could result in material adverse impacts on our results of operations and financial condition. 46
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If our investments lose value, our revenues, earnings and financial position will be materially adversely affected.
Like many other property and casualty insurance companies, we depend on income from our investment portfolio for a significant portion of our revenues and earnings. Any significant decline in our investment income as a result of falling interest rates or general market conditions would have a material adverse effect on our results. Any significant decline in the market value of our investments would reduce our shareholders' equity and our policyholders' surplus, which could impact our ability to write additional business.
The volatility and disruption of the capital and credit markets and adverse changes in the global economy may negatively impact our business.
Adverse capital and credit market conditions could affect our ability to meet liquidity needs, as well as our access to capital and cost of capital. Further, if adverse regional, national or international economic conditions persist or worsen, we could experience decreased revenues and shareholders' equity. The capital and credit markets experienced extreme volatility and disruption in the recent past. The volatility and disruption in the markets exerted downward pressure on the availability of liquidity and credit capacity for certain issuers. Our results of operations, financial condition, cash flows and statutory capital position could be materially adversely affected by continued disruptions in the capital and credit markets.
Continued deterioration in the public debt and equity markets could lead to investment losses.
The severe downturn in the public debt and equity markets in 2008, reflecting uncertainties associated with the mortgage crisis, worsening economic conditions, widening of credit spreads, bankruptcies and government intervention in large financial institutions, has resulted in significant realized and unrealized losses in our investment portfolio in the past. Depending on market conditions going forward, we could incur substantial additional realized and unrealized losses in future periods, which could have a material adverse impact on our results of operations, financial condition, debt and financial strength ratings and ability to access capital markets.
If our financial strength ratings are reduced, we may be materially adversely impacted.
Insurance companies are subject to financial strength ratings produced by external rating agencies. Higher ratings generally indicate greater financial stability and a stronger ability to pay claims. Ratings are assigned by rating agencies to insurers based upon factors that they believe are relevant to policyholders. Ratings are not recommendations to buy, hold or sell our securities. Although other agencies cover the property and casualty industry, we believe our ability to write business is most influenced by our financial strength rating from A. M. Best. According to A. M. Best, its ratings are designed to assess an insurer's financial strength and ability to meet ongoing policyholder obligations. Currently, our rating from A. M. Best is "A", or "excellent." A rating below "A-" from A. M. Best could materially adversely affect the business we write. Both Moody's and Standard & Poor's also assign financial strength ratings to the Company. Our Moody's rating is A3 and our Standard & Poor's rating is A-. While we consider our financial strength ratings from these rating agencies important, we believe that they have less impact on our business compared to our financial strength rating from A. M. Best. In addition to being assigned financial strength ratings, the Company is also assigned credit ratings. We consider our credit ratings from Moody's and Standard & Poor's to be most important with regard to our ability to access capital markets. Our current credit rating from Moody's is Baa2 with a positive outlook while our Standard & Poor's credit rating is BBB- with a positive outlook. We cannot be sure we will maintain our current investment grade credit ratings. An unfavorable change in our Moody's or Standard & Poor's credit rating to below investment grade could make it more expensive for us to access capital markets.
Risks Related to Our Company in Particular
Delay in the consummation of the Mergers could have an adverse effect on our stock price, financial condition, results of operations or business prospects.
The announcement of the Merger Agreement with Nationwide was made inSeptember 2011 , however, due to the need for a number of regulatory approvals, and approvals of the stockholders of the Company and the members of the Mutual Company and Nationwide, the Mergers are not expected to close until of the first half of 2012. While expected, the delay between 47
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announcement and closing, and the risk that the transactions will not be consummated, could disrupt our business in the following ways, among others:
• employees may experience uncertainty regarding their future roles with
the merged company, which might adversely affect the Company's ability to retain, recruit and motivate key personnel;
• the attention of the Company's management may be directed toward the
completion of the Merger and transaction-related
considerations and
may be diverted from the day-to-day business operations of the Company, and the matters related to the Merger may require commitments of time and resources that could otherwise have been devoted to other opportunities that might have been beneficial to the Company; • the Company may be unable to grow its business or implement new business initiatives given the pendency of the Merger transactions; and • third parties with business relationships with the Company may seek to terminate or renegotiate their relationships with the Company as a result of the Merger. The Merger Agreement also restricts the Company from engaging in certain activities and taking certain actions without Nationwide's approval, which could prevent us from pursuing opportunities that may arise prior to the closing of the Merger or termination of the agreement.
Any of these matters could adversely affect our financial condition, results of operations or business prospects.
Failure to complete the Merger could negatively affect our stock price and our future business and financial results.
If the Merger is not completed, for any reason, including reasons beyond our control, our ongoing business is likely to be adversely affected and we will be subject to the following risks, among others:
• we may have to pay significant costs relating to the Merger without
receiving the benefits of the Merger; • any resulting negative customer perception could adversely affect our
ability to compete for, or to win, new and renewal business in the marketplace; and
• the Company would need to re-evaluate its strategic alternatives and
operational functions, including the need to establish
retention
programs to retain employees, evaluate its investment
portfolio and
re-establish its strategic path as a stand-alone company, and may not be successful in retaining employees and re-establishing its stand-alone operational functions.
We have incurred and will continue to incur substantial transaction and Merger-related costs in connection with the Merger.
We have incurred and expect to continue to incur a number of substantial non-recurring transaction fees and other costs associated with the Merger. Additional unanticipated costs may be incurred in the integration of the merged businesses. In the event the Merger Agreement is terminated, under certain circumstances we may be required to pay Nationwide a termination fee of$29.6 million and reimburse them for their expenses.
We face significant competition from other regional and national insurance companies, agents and from self-insurance, which may result in lower revenues.
We compete with local, regional and national insurance companies, including direct writers of insurance coverage. Many of these competitors are larger than we are and many have greater financial, technical and operating resources. In addition, we face competition within each insurance agency that sells our insurance because we sell through independent agencies that represent several insurance companies. The property and casualty insurance industry is highly competitive on the basis of product, price and service. If our competitors offer products with more coverage, or price their products more aggressively, our ability to grow or renew our business may be materially adversely impacted. There are more than 200 groups writing property and 48
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casualty insurance inthe United States , and we rank among the top 60 in size. Our most significant competitors vary significantly in our different lines of business and in the geographic markets in which we compete. The Internet also could emerge as a significant source of new competition, both from existing competitors using their brand name and resources to write business through this distribution channel and from new competitors. We also face competition because of entities that self-insure, primarily in the commercial insurance market. From time to time, certain of our customers and potential customers may examine the benefits and risks of self-insurance and other alternatives to traditional insurance.
A number of new, proposed or potential legislative or industry developments could further increase competition in the property and casualty insurance industry. These developments include:
• programs in which state-sponsored entities provide property insurance in catastrophe-prone areas or other alternative market types of coverage; and • changing practices caused by the Internet, which have led to greater competition in the insurance business and, in some cases, greater expectations for customer service.
New competition from these developments could cause the supply or demand for insurance to change, which could materially adversely affect our results of operations and financial condition.
If adverse conditions in the eastern and midwestern
We primarily write property and casualty insurance business in the eastern and midwesternUnited States . Consequently, unusually severe storms or other natural or man-made disasters that destroy property in these states could materially adversely affect our operations. Our revenues and profitability also are subject to prevailing economic and regulatory conditions in the states in which we write insurance. We may be exposed to risks of adverse developments that are greater than if we conducted business nationwide.
We depend on independent insurance agents, which exposes us to risks not applicable to companies with dedicated agents.
We market and sell our insurance products through independent, non-exclusive insurance agencies. These agencies are not obligated to sell our insurance products, and generally they also sell our competitors' insurance products. As a result, our business depends in part on the marketing and sales efforts of these agencies. If we diversify and expand our business geographically, then we may need to expand our network of agencies to successfully market our products. If these agencies fail to market our products successfully, our business may be materially adversely impacted. Also, independent agents may decide to sell their businesses to banks, other insurance agencies or other businesses. Changes in ownership of agencies, or expansion of agencies through acquisition, could adversely affect an agency's ability to control growth and profitability, thereby adversely affecting our business.
If our insurance subsidiaries are not able to pay adequate dividends to us, our ability to meet our obligations and pay dividends would be adversely affected.
Our principal assets are the shares of capital stock of our insurance company subsidiaries. We principally rely on dividends from our insurance company subsidiaries to meet our obligations for paying principal and interest on outstanding debt obligations and for paying corporate expenses and dividends to stockholders. The payment of dividends by our insurance company subsidiaries is subject to regulatory restrictions and will depend on the surplus and future earnings of these subsidiaries, as well as other regulatory restrictions. As a result, we may not be able to receive dividends from these subsidiaries at times and in amounts necessary to meet our obligations or to allow us to pay dividends. If insurance regulators determine that payment of a dividend to our holding company would be detrimental to an insurance subsidiary's policyholders or creditors, because of the financial condition of the insurance subsidiary or otherwise, the regulators may block dividends that would otherwise be permitted without prior approval. Our subsidiaries are permitted under the terms of our debt agreement for our$100 million notes due 2013 to incur additional indebtedness that may restrict or prohibit the making of distributions, the payment of dividends or the making of loans by our subsidiaries to us. We cannot assure you that the agreements governing the current and future indebtedness of our subsidiaries will permit our subsidiaries to provide us with sufficient dividends, distributions or loans to fund payments on these notes when due. 49
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Although we have paid cash dividends in the past, we are currently restricted, under the Merger Agreement, from paying cash dividends, and we may not be able to pay cash dividends in the future. We have a history of paying dividends to our stockholders when sufficient cash is available. However, under the Merger Agreement we are restricted from paying cash dividends to our stockholders without the consent of Nationwide, and did not pay a fourth quarter 2011 dividend. Further, any payment of future cash dividends will depend upon our results of operations, financial condition, cash requirements and other factors, including the ability of our subsidiaries to make distributions to us, which ability is restricted in the manner previously discussed in this section.
If our use of predictive modeling or other underwriting tools is not effective, our business could be materially adversely impacted.
We use predictive modeling and other underwriting tools in underwriting a significant portion of our commercial lines business. We believe these tools allow us to more accurately match underwriting risk with pricing to operate more profitably. If the tools do not accurately reflect the level of losses that we ultimately will incur, our ability to write business and our financial results could be materially adversely affected.
If our technology initiatives are not successful, or the benefits are not realized, our business could be materially adversely affected.
Our businesses are increasingly dependent on technology. Our inability to anticipate or manage problems with technology, or fully realize the expected benefits from investments in technology, could materially adversely affect our ability to write business and could materially adversely impact our financial results.
If we lose our key personnel our business could be materially adversely affected.
The success of our business is dependent, to a large extent, on our ability to attract and retain key employees, in particular our senior officers and key management, sales, information systems, underwriting, claims and corporate personnel. Competition to attract and retain key personnel is intense. Although we have change in control agreements with a number of key managers, in general, we do not have employment contracts or non-compete arrangements with, or key person insurance covering, our employees, including our key employees.
Applicable insurance laws and certain provisions in our certificate of incorporation make it difficult to effect a change of control of our Company, and the Mutual Company has significant influence over potential change of control transactions, which could affect our share value.
Under applicable insurance laws and regulations of the states in which our subsidiaries are domiciled, no person may acquire control of us unless that person has filed a statement containing specified information with the insurance commissioner of each state and obtains advance approval for such acquisition. Under applicable laws and regulations, any person acquiring, directly or indirectly (by revocable proxy or otherwise), 10% or more of the voting stock of any other person is presumed to have acquired control of such person, and a person who beneficially acquires 10% or more of our common stock without obtaining advance approval of the insurance commissioner of each state would be in violation of applicable insurance laws and would be subject to injunctive action requiring disposition or seizure of the shares and prohibiting the voting of such shares, as well as other action determined by the insurance commissioner of each such state. In addition, many state insurance laws require prior notification to the state insurance department of a change of control of a non-domiciliary insurance company licensed to transact an insurance business in that state. Although these pre-notification statutes do not authorize the state insurance departments to disapprove the change of control, they authorize regulatory action - including a possible revocation of our authority to do business - in the affected state if particular conditions exist such as undue market concentration. Any future transactions that would constitute a change of control of us may require prior notification in the states that have pre-acquisition notification laws. As ofDecember 31, 2011 , the Mutual Company owned approximately 53% of our outstanding common stock.The Mutual Company's stock ownership and ability, by reason of such ownership, to elect our board of directors, provides it with significant influence over potential change of control transactions. Further, Section 203 of the Delaware General Corporation Law provides that if a person acquires 15% or more of our voting stock, the person is an "interested stockholder" and may not engage in "business combinations" with us for a period of three years from the time the person acquired 15% or more of our voting stock, subject to certain exceptions. Section 203 may discourage a potential change of control transaction. Our Board of Directors is divided into three classes (A, B 50
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and C). The current three-year terms of Class A, B and C directors expire in 2013, 2012 and 2014, respectively. This classification of our Board of Directors could have the effect of discouraging a potential change in control transaction.
Finally, our certificate of incorporation permits our board of directors to issue up to one million shares of preferred stock having such terms, including voting rights, as the board of directors shall fix and determine.
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